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Shareholders Versus Stakeholders

Morningstar researchers debate the best way to profit and promote social good

Editor's note: This article first appeared in the Q1 2021 issue of Morningstar magazine. Click here to subscribe.

Analysis of environmental, social, and governance risk is critical to long-term investment success. In 2020, Morningstar completed its acquisition of Sustainalytics, a leader in ESG ratings and research, and began integrating ESG risk into the cash flow forecasts and economic moat and uncertainty ratings for the 1,500-plus stocks we cover. Our analysis begins with the building blocks of Sustainalytics’ company-level ESG Risk Rating, focusing our efforts on the most material issues, thereby factoring in the most valuation-relevant risks. By capturing these factors in our intrinsic value estimate and our required margin of safety, we afford ESG a central role in our methodology in a way that aligns with our valuation focus and long-term orientation.

Hand in hand with our ongoing work analyzing investments and developing new intellectual property lies a core commitment to independent thinking. At Morningstar, we’re proud that not only do our research teams operate independently, but our analysts are encouraged to explore ideas and raise contrary viewpoints. The enemy of any research organization is groupthink. A research organization needs to hire people who aren’t afraid of challenging the status quo, and we’re always thinking about how to foster a culture where people feel comfortable speaking up and encouraging us all to think harder and sharper. We debate just about everything: Is the market overvalued? Should private equity be allowed into retirement plans? What fund categories are most suited to active investors? How much should an annuity cost?

One of the hottest areas of debate these days is whether ESG helps or hurts investing performance and what ESG risks are truly material to cash flows. What should be included in our ESG ratings, with the field of sustainable investing evolving so rapidly There’s really no facet that we don’t debate.

We asked a group of researchers from across Morningstar to represent opposing sides of a debate that’s taken center stage in 2020: shareholder capitalism versus stakeholder capitalism. One side is the view that companies should focus exclusively on serving the interests of shareholders, the owners of the stock of the company. The other view is that companies should consider the interests not just of shareholders, but also other stakeholders, such as customers, employees, suppliers, and local communities

Our debate focuses on the most famous articulation of shareholder capitalism, an article by economist Milton Friedman from the University of Chicago, which appeared in "The New York Times Magazine" in 1970.² Friedman wrote: "The discussions of the 'social responsibilities of business' are notable for their analytical looseness and lack of rigor ... In a free-enterprise, private-property system, a corporate executive is an employee of the owners of the business. He has direct responsibility to his employers. That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to the basic rules of the society, both those embodied in law and those embodied in ethical custom."

The question we posed to our debaters: “Do you agree or disagree with Friedman’s sentiment?” Team Agree took the side of Friedman in this debate, arguing that shareholder capitalism is the ideal. Team Disagree argued against this notion and for stakeholder capitalism.

On Team Agree, we have Preston Caldwell, a senior analyst who leads economics research for Morningstar Research Services’ equity team, and Nizar Tarhuni, director of research and analysis at Morningstar subsidiary PitchBook who leads the institutional research groups focused on private equity, venture, mergers and acquisitions, and emerging technologies.

For Team Disagree, we have Wilco van Heteren of Sustainalytics, who heads the enhanced rating team that focuses on the ESG Risk Rating, and Alyssa Stankiewicz, manager research analyst for Morningstar Research Services with an MBA in sustainability.

Is Shareholder Capitalism the Ideal? The following is a transcript of the debate, which was conducted on Zoom and featured during our internal company meeting in October. The discussion was edited for length and clarity.

Haywood Kelly: Each of you will have two minutes to make your opening remarks. Then, I'll ask questions of each team, and each team will ask the opposing team a question they have devised ahead of time. Finally, debaters will have one minute for closing remarks. Nizar, why don't you kick us off for Team Agree?

Nizar Tarhuni: Milton Friedman advocates that the sole responsibility of a corporate executive is to act in the best interest of her employers, which generally will be to maximize shareholder value. However, there appears to be a common misperception that these efforts leave no room for social responsibilities to be considered in the mind of the corporate executive. While we do believe that pure social responsibility should not be the primary focus of an executive to the extent that it reduces shareholder value, we live in an expanded business climate where executing on social initiatives can serve as key growth strategies that can indeed ensure higher returns to shareholders and corporations.

In fact, Friedman does provide multiple examples of this in his initial doctrine. Specifically, and I quote, “It may well be in the long-run interest of a corporation that is a major employer in a small community to devote resources to providing amenities to that community or to improving its government.”

We argue that there appears to be a false dichotomy present and that the achievement of social responsibilities and corporate profit responsibilities are not actually mutually exclusive in present-day economics. Friedman rightfully also recognizes that the situation of the individual proprietor is somewhat different, and he explains that should a sole proprietor reduce returns in order to exercise a social responsibility, he’s spending his own money and not someone else’s.

Yet today, the ownership of many companies, both public and private, includes significantly more layers than in the time that this doctrine was written. Fund structures, both those that invest in public and private securities, are backed by diverse investor groups that are investing on behalf of municipalities, colleges and universities, endowments, blue-collar pension systems, and teacher and public-servant retirement schemes, as well as many charitable foundations looking to grow wealth in order to benefit their various social activities.

As a result, in today’s environment, the social good is more baked into the fabric of corporations than may have been the case through the mid-20th century. Today, a plethora of shareholders leverage their investments to directly fund their public or nonprofit activities. We argue that corporate activities on maximizing profit actually help the social good.

Driving Innovation Kelly: Next, we'll turn to Alyssa on Team Disagree.

Alyssa Stankiewicz: I'd like to argue that Friedman's remarks aren't really relevant to what sustainable investing and stakeholder capitalism are about today. And in a few minutes, you'll hear my colleague question whether they were ever relevant. There are three main reasons for my position.

First, what Friedman and his supporters usually argue against is more appropriately termed values-based investing. These are the strategies that screen out sin stocks, such as pharmaceutical companies that manufacture birth control, regardless of the impact on investment perfor- mance. But what we see today is that sustainable investing has evolved far beyond that to focus on the combined interests of shareholders and stakeholders.

Second, ESG strategies target the relevant risks and opportunities that aren’t discernible from earnings reports. That’s why you’re hearing so much about financial materiality. As Khan, Serafeim, and Yoon wrote in a 2015 paper from Harvard,3 the research shows that "firms with good performance on material sustainability issues significantly outperformed firms with poor performance on these issues, suggesting that investments in sustainability issues are shareholder-value enhancing."

To reiterate, investments in sustainability issues are shareholder-value enhancing. Engaging stakeholders and minimizing externalities is not about feeling good. It’s simply good business.

Third, bringing it back to Friedman, there’s no concrete proof that prioritizing stakeholders, such as employees, your supply chain, or the environment, has ever led to a reduction in shareholder value. Rather, those companies that proactively engage with stakeholders are those that innovate ahead of the competition, driving strong shareholder returns for years to come.

Kelly: Now we'll turn back to Team Agree and Preston.

Preston Caldwell: First off, based on the first points made by the opposing team, I'm not sure they have anything to disagree with Friedman about. If ESG is about financial outperformance and creating shareholder value, then it sounds like they're in perfect agreement with Friedman.

I think we drastically undersell what the unabashed pursuit of profit or shareholder value can achieve. Let’s talk about some of the things that we care about in the social world. First, cheaper and better products: The pursuit of profit motivates companies to offer cheaper and better products so they can beat their competitors, and that benefits everyone.

Second, innovation: Virtually the same argument applies. Yes, innovation can be disruptive to certain so-called stakeholders. Maybe it puts some employees out of work. But innovation is indispensable to long-term economic progress. If Henry Ford had been worried about all of the horse-drawn carriage workers he was going to make unemployed thanks to his creation of an affordable automobile, maybe he would have never done it.

Next, higher real wages: The only way to generate sustainable growth and real wages is growth in productivity, and that entails reallocating labor and other resources to their best use—and that’s best incentivized by the pursuit of profit.

Finally, how about boosting diversity? Pursuing profit means that we reward workers according to how well they can do the job, not according to personal characteristics. Managers who discriminate and violate that principle are actually failing their shareholders.

Underlying all of these points is a common theme: In our free-market system, pursuit of profit delivers positive-sum outcomes that in general are in the best interest of society as a whole. What’s wrong about the stakeholder view is that it tries to make the economy into a zero-sum game where one side always wins and another loses. That runs in contrast to our entire historical experience of rising economic outcomes for society as a whole.

It’s not about shareholders winning at the expense of stakeholders. It’s about how do we deliver the most long-term prosperity for everyone. Pursuit of profit or shareholder value is the best single means we have to accomplish that.

Looking Ahead Kelly: Finally, opening comments from Wilco for Team Disagree.

Wilco van Heteren: Shareholder capitalism as it was formulated in the 1970s is a form that I don't agree with. Friedman suggests that companies and societies are disconnected spheres, almost. And, of course, they are not. Society consists of individuals. These individuals relate to each other informally—as family and friends— or formally, through governments or courts or companies. In my view, every single actor in society, be it an individual person or a company or an institution, can and should act in the interest of society.

In classical economic theory, the purpose of investing was to generate economic activity. The focus on shareholder return is much newer. Too much focus on shareholder return puts too little emphasis on the classical purpose of investing, to generate economic activity— to which I would add, economic activity that is beneficial to society.

Time is an important factor. There is short-term thinking, and there is the long term. Shareholders with a long-term horizon, like pension funds, want to make sure that they have a universe of companies to invest in, let’s say 50, maybe even 100 years from now. Focusing on short-term returns forces investee companies to focus on the short term as well, and that might not be good for that universe of companies 50 to 100 years from now.

We’ve seen examples where short-termism leads to disasters, like Enron 20 years ago, or what happened with the financial crisis in 2008 and thereafter. Look at how disturbing that was for society.

Kelly: To Team Agree, picking up on Wilco's last comment: Some of the most stringent critics of shareholder capitalism argue that it's led to some perverse outcomes, such as managerial compensation schemes that encourage executives to focus on quarterly profits that jack up the stock price. Do you agree that shareholder capitalism is more short-term- oriented than stakeholder capitalism?

Caldwell: I don't agree with that premise at all. I think if you're maximizing shareholder value, you're considering the full long-term path of cash flows. That's something that many people in the investment community like Morningstar focus a lot on: How do we maximize not only short-term profits but long term? There's nothing in focusing on the long term that's inconsistent with the Friedman view. And the notion that this Friedman view is a license to poor governance that leads to infamous episodes like Enron is ridiculous. I would make the contrary point. If we're worried about governance, then I am very much worried about the idea that we're going to dispense with the profit standard. The idea that we are going to look at profit in conjunction with these other goals is very risky. With maximizing shareholder value, we have a clear and simple standard to hold managers accountable and one that is in general optimal for maximizing welfare for society as a whole. This shouldn't be taken for granted. For much of U.S. history, corporate governance was atrocious, and it's still a problem in many emerging economies today. I worry that corrupting the shareholder-value standard will give a license to corporate manager malfeasance and incompetence and undermine a key part of the engine of our economic progress.

Kelly: Shareholder capitalism has a pretty clear yardstick for measuring success. To Team Disagree: Does stakeholder capitalism give companies clear guidance on how to behave?

Stankiewicz: Most often you hear this in reference to an oil and gas company or a company like Philip Morris PM. How should management operate when they recognize that their core business operations are in direct disagreement with stakeholder capitalism, that there are obvious risks associated with their company operations? What I would suggest to the leaders of a company like Philip Morris is that you think not in the short term, as Wilco mentioned, but look at all of the direct financial implications of your current business model in the long term and look for a way to innovate ahead of the competition. I disagree with the suggestion that considering stakeholder interests means there is a lack of clear guidance. That is a false dichotomy. Rather, I think that taking into account the broader stakeholders actually leads to a much clearer picture of a long-term strategy for a company. I would turn back to what Preston mentioned, that for the majority of U.S. history, corporate governance has been atrocious. I'm curious to know how you think Friedman helped on that topic.

Measuring Impact Kelly: Now, each team may ask the opposing team a question, starting with Team Disagree.

Stankiewicz: We've been talking about whether prioritizing shareholders means disadvantaging stakeholders. I think it's clear that it can. What about the reverse? Can you talk about a time when prioritizing stakeholders actually led to a reduction in shareholder value? Where is the proof of that trade-off?

Caldwell: It depends on how you define stake- holders. If stakeholders are the blacksmiths that are being unemployed in your local community because you’re making advancement in metallurgic technology, then that would be an example. If it’s assembly line workers who are being cut out by automation, which leads to productivity, which leads to long-term economic growth and higher real wages, then that’s an example where the interest of a few privileged stakeholders actually runs against not only the interests of shareholders, but the interest of society overall. Those are pretty clear examples in my mind.

Tarhuni: I would just add that I think people misconstrue Friedman's quote as meaning that focusing on stakeholders is always a poor idea. Rather, focusing on stakeholders when shareholder value will be eroded is the problem. There are countless examples where taking into account social good and the interests of stakeholders also helps the profit motive of the corporation. And I think that, scaled across the economy, adds a lot more value for various stakeholders in the economy.

Kelly: Team Disagree, would you like to respond?

Van Heteren: What is the interest of the shareholder is still an open question. Economic returns are still too often understood as monetary returns. I think it's about to shift to a paradigm where we also look at societal impacts and impacts on our planet, and there will certainly be alignment. Today's discussion shows that there may be much more alignment today among all these interests than maybe there was in the '70s, when there was a big push to oppose capitalism from communism. There was a historical component to that. But I would say that an economic system that looks at the impact an economic actor has on the planet and on society, and defines shareholder return around that impact, is the way forward.

Kelly: Let's turn it over to Team Agree for their question.

Caldwell: Let's get into the nitty-gritty. How do you propose to weight goals other than shareholder value? Who in a corporation decides what the weights are and who gets the privileged status of being a stakeholder?

Van Heteren: There's a whole field of economic thinking that is in motion, trying to measure the impact that a company has on society and on the planet and also to define shareholder interests around that type of impact. Look at sustainable investing and how it has moved from screening out companies to getting involved with the companies that you're investing in. And the range of interests being considered has also evolved. Classically speaking, stakeholders are employees, local communities where companies are operating, and suppliers. But you can add to that consumers, politicians, lobbyists, whatever. Sustainability is about lifting the entire platform higher, where the actors on the platform are all these stakeholders, like companies, employees, suppliers, basically everybody. We should make an effort to lift the platform higher so that all benefit.

Kelly: Team Agree, would you like to respond?

Caldwell: We already have a pretty good standard for evaluating the needs of various connected actors in society, which is profit, because it sends a signal of the various interests and welfare of everybody in society. I'm not trying to argue that the pursuit of profit is always perfect. I'm very supportive of the idea there are certain problems that have to be addressed, not by the market, but by government. Climate change is a textbook example. It's what an economist would call a market failure, but the best way to address that is with government policy, ideally a carbon tax.

The way not to deal with problems like climate change, is to create a bubble of inflated expectations about what private economic actors can do on their own. The bubble won’t last forever, and once it bursts, what are you left with? You don’t have a sustainable policy to address this issue.

In Closing Kelly: Debaters, you now have one minute each to make your closing remarks.

Stankiewicz: Stakeholder engagement isn't just the dispersion of shareholders that rely on about feeling good. It drives innovation and superior shareholder returns. Take Ben & Jerry's, whose loyal customer base isn't driven by the ice cream itself, but by the social initiatives that company supports. The milk for their ice cream comes from farms in Vermont, many of which are struggling from soil degradation, so Ben & Jerry's is leading research on regenerative agriculture. It supports the community it operates in and ensures the viability of its supply chain in the long term. Furthermore, there is no negative impact to investor returns. Oil and gas companies have myriad ways to inflate short-term returns, but investors care about the long term. Like it or not, our society is becoming more interconnected. It's better to engage with those stakeholders sooner than later, for the sake of investors.

Tarhuni: Corporate growth has undoubtedly underpinned both global economic and public-sector growth for decades. As for the idea that corporate earnings can only be achieved at the expense of broader social or sustainable responsibilities, we argue that our economies and financial markets have never been more connected than they are today. As a result, the focus of executives on corporate earnings and shareholder value is actually the clearest and best strategy to maximize funding for social and sustainable initiatives in the public good.

It’s imperative that we recognize that there’s this false dichotomy present between financial and social incentives, and that we acknowledge the dispersion of shareholders that rely on corporate earnings, so that we don’t fall into a trap that actually hinders the very social activities that we can help fund with corporate profit.

Van Heteren: Any economic actor--whether consumers, businesses, investors, or us analysts--knows that they always have a choice to take a long-term, holistic view on what in the end is good for society. The 1970s interpretation of shareholder capitalism has resulted in short-term thinking, which has had damaging effects on the planet and society. Think of the exploitation of natural resources and the impact on biodiversity. Think of the financial crisis. It's time that we all see each other as living beings on the planet. As human beings, we are part of one holistic network, and new economic theories are emerging based on that thinking. They are less adversarial than "shareholders versus society," but more holistic.

Caldwell: We've had financial crises for at least 200 years, and we've had much worse problems in terms of pollution, with an energy-intensive economy. Noncapitalist economies like the Soviet Union and China's semicapitalist, semisocialist economy have had far more problems with pollution than free-market economies have had.

I want to make a simple observation: In 2020, the average U.S. citizen is roughly 6 times richer than they were 100 years ago and perhaps 25 times richer than they were in 1800. And likewise for the world. I’ll quote historian Brad DeLong, who is far from a free-market ideologue. He says even lower-middle-class households today in relatively poor countries have standards of living that would make them the envy of the powerful and lordly of centuries past.

Suffice it to say, our lives have changed beyond recognition for the better. And at the heart of that growth, which has made everyone better off, is the pursuit of profit, which today translates into shareholder value. Imagine how much better things will be 100 years from now. Do we really want to forsake the principle that has been at the root of that progress? I think not.

Kelly: Thank you for a thoughtful discussion.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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